How to invest wisely for better returns

Factor investing utilises various determinants ranging from macroeconomic to fundamental to statistical, in a way to understand their influence on the outcomes, employing them to derive the desired results. The usual and popular factors include capitalisation based (large/mid/small, etc.) to style based (growth, value, etc.) volatility based (momentum, low volatile, etc.) and even credit rating (in bonds, debt, etc.)

The very essence of investing is to generate returns. It’s not returns that investors seek but better returns that’s where relativity kicks in. Better than the broader markets, industry averages and benchmarks. That’s how the argument goes. These’re expressed in Greek, alpha (α), the excess return over a benchmark and beta (β) the relative correlation to the broader market, i.e., market equivalent return.

And there’s no perfect or fool-proof way to make better returns. There’re more than many ways to succeed in investing and that’s a feature, not a flaw. However, more and more research points to the psychological aspect of the investor are influencing the investing outcome. While there’re many models that could perform better in the market, the individual’s decision making becomes key. If the investor doesn’t act on a cue when the market presents or acts when it is not meant to, then the consequences would be far away from the desired.

When we set to achieve something in life, like health or career, we identify certain important attributes that determine the outcome. Things like nutrients and exercise in health while academics and experience would become driving force for success extending to even excellence in career. Similarly, in investing, there’re some crucial aspects that could influence the positive output of an envisaged plan. This field of identifying these factors and devising an investment philosophy is known as factor investing. Factor investing involves in targeting specific drivers of returns across asset classes. This could not only just improve returns but reduce volatility and enhance diversification.

Factor investing utilises various determinants ranging from macroeconomic to fundamental to statistical, in a way to understand their influence on the outcomes, employing them to derive the desired results. The usual and popular factors include capitalisation based (large/mid/small, etc.) to style based (growth, value, etc.) volatility based (momentum, low volatile, etc.) and even credit rating (in bonds, debt, etc.)

While everyone strives to achieve better returns, the use of factors or quants predisposes the decision-making process by reducing if not eliminating the human biases or errors. The various investment calls would be filtered through a process stipulated by these factors which in turn derive the list that would be played upon. This streamlines the criterion for the selection of securities thus narrowing the options to act upon to on a pre-defined strategy.

While the origins of this approach go back to 1970s, when empirical models began to question the Capital Asset Portfolio Model (CAPM) and Efficient Market Hypothesis (EMH) but only post the GFC (great financial crisis) this became more popular. Over the years, dozens of purported factors have been identified but instead of considering all, a few of the relevant ones are zeroed. The requirements of any factor are performance, proof, persistence, explainable and executability. On this filtration the common equity factors derived viz., value, size, momentum, quality and low volatility. A few more like dividend yield and income.

A crucial advantage of factor investing is to improve diversification to the portfolio.There’re no better or worse factors to be considered among these but investors should consider their goals in picking the factor(s). Each of them could achieve different outcomes and depending upon their priorities, investors could pick one or a combination of factors for their investment strategy.

A combination of factors with low correlation could outperform in different market conditions. By investing across multiple factors, investors end up reducing risk and generate better risk adjusted returns. For instance, during bullish phases of the markets the size and growth factors tend to do well along with the momentum while quality usually performs relatively better in a bearish phase.

In recent years, however, products exploiting low-risk or low-volatility factors have been broadly accepted. The empirical evidence suggests that securities generating stable returns relative to the broader market have achieved higher risk-adjusted returns than riskier ones over the long term. Various reasons were put forth by academics to explain this anomaly, the most frequent relates to the rational behavior of the fund managers whose performance is usually evaluated against a benchmark. Therefore, they tend to focus on being able to deliver outperformance and on minimising relative risk, thus tend to overlook low-risk stocks which are characterised with market-like returns and high tracking error.

Many of the factor investing models are usually played through passive investing i.e., through factor-based ETF (exchange traded funds). Some of the available options are Nifty Value 20 index, Nifty 200 momentum 30, Nifty 100 low volatility 30 and Nifty Quality 30, etc. are some of the commonly used indices. By employing a combination of such factors stocks are selected and weights are capped in the index. Funds like DSP Equal Nifty 50, ICICI Pru Nifty Low Vol 30 ETF, Edelweiss EFT Nifty 100 Quality 30 and Sundaram Smart Nifty 100 Equal Weight Fund utilise factors to invest.

Though, in theory they present a compelling case for investing, one should be judicious in employing them. Certainly, a combination of factors and active funds could allow for better diversification particularly in the large cap space where there’s been a higher underperformance by the active funds in recent years. Also, exposure to a micro-cap index fund could add a flavour of the last known listed universe to the portfolio.

The author is a co-founder of “Wealocity”, a wealth management firm and could be reached at [email protected]